Raising 100% Development Finance

Property developers are increasingly resorting to 100% development finance in order to maximise their return on capital.

Whilst 100% finance generally involves giving some of the development profit away, it allows developers to engage in larger projects than they would otherwise be able to or simply to take on more projects, spread their exposure and maximise profits. Here are some of the key points for this type of funding:

• A clear Market Value must be determined by a RICS valuer and support the purchase price a developer proposes to pay. A RICS supported Market Value will corroborate the economic value of a site purchased for development by ascertaining the value of the completed development (Gross Development Value), the construction and financing costs involved in the development, a fair return for the developer and, by deduction, the resulting value of the site (or residual valuation). The typical profit a developer should expect to make for a project where the site is bought at market value is 20% although this may vary depending on the likelihood (or certainty) of sales on completion as well as the type of property he builds.

• When considering 100% development funding, lenders will be extremely diligent in evaluating the commercial risks involved in the project. There are two key types of risk:
  • Development risk: this relates to any risks involved in the delivery of the project and lenders will want to get the maximum level of confidence as to the developer’s ability to complete a project on time and on budget. A solid track record in delivering similar projects will be necessary as well as demonstration of sufficient financial strength in the event of an escalation in costs. Lenders will almost certainly require a cost overrun guarantee (and evidence of the developer’s ability to make good on such guarantee). Some lenders will accept a cap on such guarantees, but others may not.
  • Market risk: this relates to the risk of not being able to find a buyer or tenant for a completed project. Development lenders expect their facilities to be repaid on completion of the construction project and will want to get comfort that there is a valid exit (sale or let). Any delay in the exit will entail further interest charges and erosion of the profitability. A lender will therefore rely heavily on the views of valuers and agents and seek assurance that the Gross Development Value is realistic and that there is demand for the properties to be built at those values. It is possible to minimise market risk by way of forward sale or forward let provided the forward purchaser or tenant is a credible and credit worthy party.

• Funding structures: depending on the type of developments, it may be possible to fund 100% of total costs with one single lender but it generally is more common to structure a funding package with two or three types of lenders: senior, mezzanine and/or equity.
  • Senior lenders: these lenders will typically not go beyond 75% of total costs or 65% of GDV. Some lenders are more aggressive than others but they tend to focus on specific types of developments and it pays to know which lender likes what type of development project. Red Chilli Structured Finance has an intimate knowledge of all lenders’ criteria and can find the most suitable lender for any given project.
  • Mezzanine lenders: these lenders will fund a riskier “slice” on top of the senior lender’s facility and will typically charge a much higher rate in exchange for taking greater risk. That rate will however only apply to a relatively thin slice (typically circa 15% to 20% of costs) so it is important to consider the blended rate between the senior and mezz facility when considering the cost of such a funding structure.
  • Equity lenders: these lenders typically inject the top slice into a project and share the risk with the developer in exchange for a share of the profits. That share varies widely and depends on the quality of the project, the asset class, the likely exit and of course the developer’s track record.

It is worth noting that there is no single structure that suits all projects. It is important to structure the funding package by bringing together the most suitable lenders for a given project. Red Chilli Structured Finance can advise on the best structure for specific deals by ensuring that there is optimal fit between the type of development, its economics and the criteria of all different lenders in the market place. Furthermore, different structures must be envisaged depending on the developer’s outlook. A stretched mezzanine facility which attracts a fixed coupon each month may be better suited to a developer who feels he is likely to achieve pre-sales early on as Red Chilli would seek a senior lender willing to extend its facility to pay back the mezzanine once a certain level of pre-sales is achieved. This will allow the developer to reduce the cost of the facility as soon as a pre-sales target has been reached rather than pay an equity provider a fixed share of the profit no matter how many pre-sales are contracted. With stretched mezzanine, there is an incentive for the developer to de-risk a project early on – any discount that he may grant to forward purchasers being offset against the savings achieved by repaying the mezz slice.

On the other hand, a developer expecting to achieve maximum sales prices only once the project is fully completed (more likely on a very high end residential development for example where prospective buyers will want to see the finished product) is likely to prefer an equity partner willing to stay the course and share the risk until the end.
There are also a number of ways to de-risk development projects and therefore to make it more likely for a senior lender to offer a highly geared facility, thereby reducing or negating the need for mezzanine or equity facilities.

Red Chilli Structured Finance has extensive experience in structuring 100% development finance

Contact us today (whether you are experienced or not) for an exploratory chat and see how we can help you achieve your goals and maximise your profits.

Related

• Residential Development Funding QT4 2009 Outlook
• 100% development finance - a dead end?
• The Re-emergence of Mezzanine Finance in the Property Industry
• Residential Development funding in 2009
• Property Development Finance - London